Monday, August 4, 2008

Picking apart Fannie Mae – PART ONE

Warning: This post in this form contains NO conclusions. I do not express a position on whether the stock is a long or short. I hope to get there by Part III - at the moment I am just conducting an intellectual exercise for me and my readers.

I have had hostile email suggesting that I couldn't possibly suggesting that the stock is a long. I am not. And I will not without a close examination. And I won't suggest its a short without a similar examination. That is the way I want this blog to work...

There has been an awful lot said about Fannie Mae and Freddie Mac of late.Almost none of it contained numbers.If they contained numbers they were just off-the-bat (ie analysis free) estimates of what a bailout might cost.

I can understand why.I had a go at picking apart Fannie Mae.The deleted post can be found here.It was one of the more embarrassing mistakes I have made.I just left a zero off a calculation and produced nonsense.Moreover I ran the calculation past one of the best known hedge fund managers in the world – and he never noticed the missing zero either. (One of my precious readers pointed it out – keep those emails coming.)My hedge fund manager friend doesn’t publish a blog – so you don’t see his mistakes…I assure you he makes them…

Picking apart the numbers is fraught with difficulty.Very few of us are used to thinking in trillions – and the rules of thumb we develop (is that a big number or a little number) become useless.I left off a zero and because the number was so big it didn’t seem too small…

This is the first part of an attempt at picking apart Fannie Mae.I started writing this without any preconception as to whether you want to be long or short.I might wind up at a conclusion – but forgive me if I sound vague or indecisive.That truly reflects my state of mind.You will find out the conclusions the way that I am finding them out – by actually running through the numbers.

Disclosure: I once knew an awful lot about Fannie Mae.I fully understood their accounting fraud before it was disclosed.Indeed I could accurately count the size of the fraud (and I was correct within a couple of billion dollars).I never understood why OFHEO with 200 staff could not (or would not) see it. I was short a lot of Fannie Mae and – whilst I made some coin – I was genuinely shocked at how little interest the market took in Fannie’s misdeeds.Having not made much money when I was right I went on to work out other ways to be right not make money – and I let my detailed knowledge of Fannie Mae lapse.

The range of outcomes to this project is enormous.It could be that

Fannie is shockingly insolvent – and hence to be avoided like plague or

The problems are overstated and Fannie is solvent – moreover because the competition has been removed it is likely to be far more profitable in the future than it ever has been in the past – and you should buy it because its best days are in front of it.

I am trying to start this project with no opinion.

I apologise to bond market experts who might read this post.The first bit assumes you don’t know what “negative convexity” means or how to measure it.I am going to try do this without much bond market jargon.

How Fannie Mae makes money

Fannie Mae is in two businesses.

The guarantee business: Fannie Mae bundles up mortgages, guarantees them and sells them as “pass-through certificates”.In this business it takes only credit and fraud risk and it earns only guarantee fees.

The portfolio business: Fannie Mae also buys mortgages for its own balance sheet and funds them using wholesale borrowings.It borrows money fairly cheaply because of a quasi-government guarantee.This allows it to make a reasonable spread by owning mortgages.However in this business it takes funding risk and interest rate risk.Because it owns the mortgages and will suffer if they default it also takes credit risk.

Now for those that are not familiar with the inner-workings of Fannie Mae I will surprise you.By far the most important business is the portfolio business.The spreads are much larger in that business and the business usually generates the bulk of Fannie’s revenue.It is also where the accounting frauds were found.

Mismanagement of the portfolio business has – over the years – cost Fannie tens of billions of dollars.The reason why Fannie has so little capital and credibility going into this cycle is that it stuffed this business up comprehensively.

The guarantee business is what is causing Fannie a lot of trouble now has – for most of Fannie’s history been trouble free.[Standard mortgages had a very low default rate until this cycle.]

This table gives from p.46 of the last annual report details Fannie’s total exposures.[Warning – head for large numbers needed as the numbers are in millions.]

year end data

2007

2006

2005

2004

2003

Mortgage portfolio

727,903

728,932

737,889

917,209

908,868

Fannie Mae MBS held by third parties

2,118,909

1,777,550

1,598,918

1,408,047

1,300,520

Other guarantees

41,588

19,747

19,152

14,825

13,168

Mortgage credit book of business

2,888,400

2,526,229

2,355,959

2,340,081

2,222,556

Since Fannie got into trouble on interest rate risk it has shrunk the portfolio business from 917 billion to 727 billion.It however sharply increased the guarantee book of business.

The credit guarantee fees are low – but are rising.The credit costs have been very low until recently (a single basis point).They were easily manageable last year.Here are the average fees and credit costs for the past five full years.

2007

2006

2005

2004

2003

Average effective guarantee fee (in points)

23.7

22.2

22.3

21.8

21.9

Credit loss ratio (in points)

5.3

2.2

1.1

1.0

1.0

These tables are not strictly comparable because one table is year end and the other is year average.However ignoring this complication we can see that the guarantee business would have been very profitable in all years (but almost certainly loss making in 2008 and 2009).

The thing that is startling is how low the guarantee fees are.In 2003 Fannie Mae had 2.2 trillion of credit exposure.If you take 21.9 bps on this the total guarantee revenue would have been well under 5 billion.Indeed the annual report gives them as 3.4 billion – but it does not classify the profit from some credit exposure in on-balance sheet mortgages as guarantee income.

5 billion sounds a lot – but the post tax profit of Fannie Mae in 2003 on the restated accounts available to shareholders is almost 8 billion.The money wasn’t made on the guarantee business – it was made on the portfolio business.

Given that the profits historically came from the portfolio business we need to understand the portfolio business to see how it really makes its money.

The portfolio business

Fannie Mae buys mortgages.It finances them by issuing debt – “reference notes” and the like with a quasi-guarantee from the US Treasury – and makes a spread.This is old-fashioned banking business – but Fannie doesn’t take deposits.

There are a few problems with this.The first problem is that Fannie actually has to borrow the money and be able to ensure that it can always borrow the money.If Fannie can’t borrow it will fail.That almost happened recently – but since the Feds have made it clear that they stand behind Fannie it is unlikely to happen again.It’s a real risk though.I have made it clear many times (here, here) that the biggest risk faced by many banks is the ability to finance themselves.Government guarantees help a lot though.

The second problem is more continual.Fannie Mae has no idea what the duration of the mortgages it owns is.This was a very big problem indeed in the period 1999 to 2004 when there were massive waves of mortgage refinance in America.The mortgages might last ten years – or they might refinance next week.This could (and did) cause massive problems for Fannie.

The logic is as follows.

Imagine rates were to rise a lot – so that people were very reluctant to refinance and the lifespan of the mortgages were to extend to ten years.Then Fannie would want to have its financing fixed for ten years.Otherwise there could be a real problem.If the financing wasn’t fixed then the funding cost would rise and Fannie’s spread would go negative.If you are levered as many times as Fannie a large negative spread will make you insolvent quite rapidly.So when rates rose Fannie wanted to have its financing fixed.

However if rates were to fall everyone would run off to their broker (this was 2004 remember) and refinance at a lower rate.If Fannie had fixed its finance it would now have ten year finance for ten years it would now own low-yielding mortgages with old high-cost finance.The spread would be negative again.Of course it would be alright if Fannie were floating-rate financed because as rates fell the finance cost would also fall.

So Fannie had to perform the neat trick of having fixed cost financing whenever rates rose and floating rate financing whenever rates fell.

This is of course impossible.

But you can come pretty close using derivatives.What you would do is have finance of a mix of durations and buy “interest rate swaptions”.The “swaption” would give you an option to enter an interest rate swap (ie to fix or unfix your finance) at various times.That way Fannie could fix its finance when rates were rising or have floating finance when rates were falling.The swaptions were of course expensive.

Fannie could (and did) also hedge its interest rate risk by other methods including:

·issuing callable debt (which is clean but expensive and was favoured by Freddie Mac), and

·delta hedging (which is a trick of high finance that involves selling things when they fall in price and buying them back when they rise in price and hence losing money which is expensive).

You will notice that all these hedging methods are expensive and Fannie thus continuously lost money on derivatives.Derivative fair value losses at Fannie have over the past five years totalled 28 billion.(You need a lot of spread to make that up and make a profit – and Fannie made a profit in those five years.)

The frauds at Fannie were in the derivative accounting.The accounting is also a mess because Fannie accounts for the derivatives on a mark-to-market basis but accounts the spread on a yield to maturity basis.This mismatch makes the accounts incomprehensible to almost everyone (including myself most the time).

I won’t tell you how I worked out the fraud and quantified it – but Peter Eavis (a fine journalist if there ever was one) worked out a fair bit of it and put it here.

One thing that made the portfolio business hard was that the mortgage market was huge relative to the treasury market.To hedge risk Fannie needed to trade in the treasury market or buy swaptions from people who traded in the treasury market.The size of this trading moved treasury prices – and the resulting changes in interest rates were always to the detriment of Fannie.The size of Fannie and Freddie relative to the market for US Treasuries made it difficult for Fannie to hedge.

The decline of the portfolio business

Before the mortgage crisis hit the Fannie Mae portfolio business went into very sharp decline.The profitability of Fannie Mae shows this – dropping from 8 billion in 2003 to 3.5 billion in 2006 even though the book of guaranteed business continued to rise. Even a tick-up in guarantee fees could not offset the profit decline.

There are a few reasons for this.I haven’t quantified these in order of importance but I suspect (with limited evidence) that the last one is probably the single biggest factor:

Yield curves got less steep – and so Fannie lost the option of financing at close to 1 percent and lending at 5 percent.

Fannie shrank the “owned balance sheet” under regulatory pressure – from over 900 billion to just over 700 billion.

Fannie reduced the amount of risk it carried – by buying more swaptions and issuing more callable debt.Lowering risk lowered profit.You can see the lowered risk because the “effective duration gap” that Fannie is running has fallen sharply over the years.[The duration gap is published in Fannie’s monthly data.A duration gap that jumps around a lot indicates that a lot of interest rate risk is being taken.At ones stage the published duration gap got over a year – which is an awful lot when you are levered as much as Fannie Mae.On a trillion dollars of mortgages a one percentage adverse movement in rates across the curve will cost you 10 billion dollars if you have a one year duration gap.The duration gap is now normally less than a month.]

Fannie let the book run off resulting in a natural decline of spread.

The natural decline in spread as you run the book off is second nature to anyone who deals with mortgages but is not obvious to outsiders.It’s as follows:

In any pool of mortgages there are a few that will last a long time and a few that will refinance next year.If you “match” finance them you will have some finance that matures in a long time and some that matures next year.

The short dated finance is cheaper because the “yield curve” generally slopes upward.So the mortgages that don’t last very long have more spread in them than the mortgages that last a long time.As the book runs off you are left only with the low-spread business.

Anyway – however you count it Fannie Mae’s spread based portfolio business ran off – and its credit guarantee business expanded – just in time for the credit losses to hit them hard.Expanding credit risk into a crunch can’t be much fun!

A possible re-emergence of the portfolio business

Fannie’s reduced reliance on portfolio business is a pity – because if you haven’t noticed the yield curve is quite steep at the moment, interest rates are not massively volatile (reducing the cost of the hedging), and Fannie’s funding advantages are intact courtesy of Paulson et al.

Moreover Fannie can hedge far more easily now in the Treasury market because the Treasury market has grown so massively courtesy of 43s incessant government deficits.

If Fannie were to grow the spread business now it would do so at high spreads.If it were to chose to (or be allowed to) run considerable interest rate risk it could easily get the spread to 120bps (an old level).All treasuries under ten years yield under 4.2 percent.Some shorter dates yield under 2 percent.Fannie should be able to finance at 50-70bps more than Treasuries especially with explicit Treasury guarantees.

The yield on an on-the-run wholesale mortgage with a Fannie guarantee is about 6 percent.[See this graph.]Depending on where on the yield curve Fannie finances it will pick up something like one and a bit to three and a bit percentage points of spread.The “swaptions” will reduce this – but it should be possible to earn 140bps spread on 700 billion of owned mortgages if Fannie whilst hedging a fair bit – but by no means all of their interest rate risk.[They could go bust on that risk – so this is a non-trivial caveat.]140bps annually on 700 billion is over 10 billion per annum.

Rising revenue on guarantee business

It is also entirely possible for Fannie to raise the guarantee charge on new mortgages to well over 30 bps – and the fee on the whole book will continue to rise.My guess is that the guarantee fee will rapidly go to 30bps - but 25 is a gimme.[The quasi government guarantee is worth a lot in this time of uncertainty.]

The Treasury guarantee and lack of competition will allow the guaranteed amount to go to 3 trillion.25bps on 3 trillion is 7.5 billion.Guarantee fees were over 5 billion last year and rising rapidly – so this is not a stretch.

This looks very like 17.5 billion in revenue.

Sanity check on revenue numbers

I am back working out what the revenue numbers might be not what they are.They are considerably lower primarily because Fannie has spent the last three years shedding interest rate risk.[One of those funny things – Fannie made the same mistake as me – being petrified about interest rate risk when the right thing was to be petrified about credit risk.]

The guarantee figure estimate (7.5 billion per annum) is probably low.The last quarter the number was 1.7 billion up from just over 1 billion.At this rate of change we are very likely to get to guarantee fee income of 10 billion at some stage.Certainly the credit crisis is driving guarantee fee revenue skyward.The average effective guarantee fee is now 29.5 bps.This has risen about 50 percent since the early parts of this century.

Interest rate income is much harder to estimate.The accounting for this always sucked because you never knew what the right level of derivative expense to include was.

Net interest income was over 1600 million for the quarter – but there was over 4000 million in “fair value losses”.On that front it was not a good quarter.But the “fair value losses” are a mark-to-market concept and the interest income is a yield to maturity concept.Still if the revenue pre-derivative cost is 1.6 billion per quarter I ain’t getting to 17.5 billion per year.I am not even getting to 10 billion.Sure the 1600 is up from 1000 million quarterly as the situation gets better in the portfolio business.But unless Fannie again takes some serious interest rate risk the portfolio business is going to be stuck earning less than 6-8 billion annually.

My sanity check fails.But the possibility exists that Fannie will surreptitiously up the interest rate risk again.In which case we can get big revenue numbers.The problem is that it wasn’t very nice last time they tried it!

So let us take the low-ball numbers.The low ball numbers are revenue for guarantee business if 7.5 billion per annum, and revenue for the portfolio business of 6 billion per annum – total revenue of 13.5 billion.

Expenses other than credit losses and mark-to-market expenses

Fannie is just a big financial machine with very few staff which makes money on guarantee fees and interest rate spreads and loses it on credit and derivative hedging costs.Staff costs are close to irrelevant.Administrative expenses are about 500 million per quarter and falling.[There are half a billion of other non-interest expenses in the first quarter – but they are minorities and debt extinguishment costs and shouldn’t really concern this analysis.]

So pre-credit cost profits of Fannie are about 2 billion per annum.They will rise as credit remediation costs rise – but let’s be nasty and call it 3 billion per annum.

Pre-credit costs profits of Fannie

On this calculation the pre-tax, pre-credit cost profits of Fannie Mae will be about 10.5 billion per annum.It will be wildly volatile because the accounts of Fannie are wildly volatile due to mismatches between the portfolio and the portfolio hedges.But that – I believe – is about the underlying run-rate.

Credit costs – the problem of the moment

To date Fannie’s big problems – the ones that caused them to raise capital last time and restate – were interest rate hedging losses.Now it has credit problems.And nobody really has any good idea of how bad the situation is.

But let’s dismiss some alarmist stuff.There were plenty of alarmist pieces about how much housing stock Fannie Mae owns right now.This article suggests that Fannie and Freddie combined owned 6.9 billion of forclosed real estate – less than 5 billion of which is at Fannie Mae.They might lose 30% on it (though even that is not clear).

Well let me say at the outset that those losses are irrelevant.If they had a loss after foreclosure of 50 percent they wipe out about three months of earnings.That would be no threat.

The real estate inventory that Fannie is currently sitting on – being many thousands of houses and many thousands of families in personal tragedy – is irrelevant financially to Fannie Mae.So steer clear of the alarmist stuff.If Fannie only winds up with say 15 billion of foreclosed real estate it will skate through this crisis just fine.

What we need to really hurt is 50 billion of losses over three years – maybe 20 times Fannie’s current inventory or real-estate-owned (REO) needs to pass through Fannie’s ownership.That would wipe out three years’ profit, plus 20 billion in capital and cause all sorts of social and regulatory stress. [We could also blow up on interest rate risk!]

In summary: if the losses are less than 20 billion you will do OK buying Fannie on any of the panics.If the losses are say 50 billion the financial and regulatory stress will be such that Fannie is problematic.

If the losses are 70 billion – say seven year pre-tax earnings – then Fannie sucks as investment and the best you can hope for is a number of dilutionary capital raises.That is if the Feds don’t just confiscate it from you.

But to want to be short Fannie on the fundamentals you need the real estate owned to wind up more than ten times the current (horrific) level of inventory.

Does that happen?My instinct is no – but I would prefer examine the numbers.

I have no idea on the extent to which changes in family size, status of marriage et al have exacerbated the mortgage crisis.

I have a friend who is a demographer - and with his demographer's bias he thinks everything is caused by demographics.

But the general rule has been that in the west household size has shrunk leading to smaller households for any given population.

This should have meant that say flash apartments did well versus family houses.

But that hardly explains the San Fernandino valley.

So I can't get an obvious demographic trend. My guess is more that house prices have been driven by the things I can see - lax lending, and a sudden tightening in lending standards - and changes in income distribution.

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The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.